The time value of money is a fundamental financial concept that states that money received today are worth more than money received later. At its most fundamental level, the time value of money shows that all other things being equal, it appears to be better to have money now rather than later. This is true because the money you have now can be invested and produce a profit, resulting in a larger sum of money in the future. Also, with future money, there is the possibility that the money will never be received, for whatever reason. The net present value (NPV) of money is another term for the time worth of money.
How the Time Value of Money Works
To demonstrate the time value of money, let me use a simple scenario. Assume you are offered $1,000 now or $1,100 in a year for some service you are doing for someone you work for.
Which payment method should you choose? It all depends on what kind of investment return you can get on your money right now. Because $1,100 is 110% of $1,000, you should take the $1,000 now if you believe you can get more than a 10% return on the money by investing it over the next year. If you don’t think you’ll be able to earn more than 9% in the following year by investing the money, you should accept the $1,100 future payment – as long as you trust the individual to pay you then.
Because a sum of money, once invested, grows over time, investors prefer to receive money today rather than the same amount of money in the future. Money placed in a savings account, for example, earns interest. Interest is added to the principal over time, earning more interest. Compound interest has that kind of power. The value of money depreciates over time if it is not invested. Because of inflation, it will have even less purchasing power when you get it back.
Time Value and Purchasing Power
Inflation and buying power are both related to the concept of the time value of money. Both aspects must be considered, as well as the potential rate of return on investment.
What is the significance of this? Because money’s worth, and so its purchasing power, is constantly eroded by inflation. The pricing of goods like gas and food are the finest examples. If you were given a coupon for NGN10,000 worth of free gasoline in 1990, you could have purchased a lot more gallons than if you were given NGN10000 worth of free petrol now.
When investing money, you must account for inflation and buying power because you must subtract the rate of inflation from the percentage return you gain on your money to calculate your real return.
Though the rate of inflation is higher than the rate of return on your investment, you are actually losing money in terms of purchasing power, even if your investment shows a nominal positive return. If you earn 10% on investments but inflation is 15%, you will lose 5% of your purchasing power each year (10% – 15% = -5%).
Time Value and Financial Management
TVM is vital for financial management since money is worth more now than it will be in the future. You can always put the money into an investment and earn interest on it. When investing, however, you must consider the opportunity costs.
Wherever options are available, opportunity costs arise. As a result, opportunity costs are the benefits or interest that one foregoes while choosing one investment over another. Opportunity costs, to put it another way, are the next best available and desired investment. As a result, opportunity costs should be considered while making an investment decision. TVM’s concept of opportunity costs aids decision-making.
The temporal worth of money is important not only for business decisions, but also for personal ones. Understanding the TVM idea will enable you to see the financial implications of every financial action you make. It would assist you in setting financial goals and overcoming financial obstacles. It could also assist you in comparing and contrasting two or more investment possibilities. Someone might offer you to lend him $5000 now in exchange for $5,500 a year later. At first glance, it appears to be a good investment because you get an extra $500. To get the true picture, you must take into account the TVM. This investment is not worthwhile if the PV of the future amount is less than the current amount.
The formula for Time Value of Money
The concept of time worth of money is significant not only for individuals but also for corporate choices. When it comes to investing in new product development, acquiring new company equipment or facilities, and creating credit conditions for the sale of their products or services, companies consider the time value of money. The time value of the money formula may vary slightly depending on the circumstances. The generalised formula, for example, contains more or fewer components in the case of annuity or perpetuity payments. However, the simplest basic TVM formula takes into account the variables listed below.
- FV = Future value of money
- PV = Present value of money
- i = interest rate
- n = number of compounding periods per year
- t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t)
Using the formula above, let’s look at an example where you have NGN50,000 and can expect to earn 5% interest on that sum each year for the next two years. Assuming the interest is only compounded annually, the future value of your NGN50,000 today can be calculated as follows:
FV = NGN50,000 x (1 + (5% / 1) ^ (1 x 2) = NGN55,125.00
The financial takeaway
Understanding the time value of money is critical for personal finance. It can assist you in determining how much to budget, evaluating a job offer, determining whether a loan is a good deal, and saving for the future. TVM demonstrates how inflation causes your money to lose value over time.
Apply the TVM formula to any loans you have to see if paying them off or investing is a better option. It can also be used to assess how raising your retirement contributions will affect the value of your money in the future. It’s a fantastic tool that provides you with data that can assist you in making better financial decisions.
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